Employmentand Labour Market Policies Branch

EmploymEnt Working Paper No. 182

Employment policy Department

2015

Gerald Epstein

Development central banking: A review of issues and experiences

Empl

oym

Ent

Employment Policy Department EMPLOYMENT Working Paper No. 182

2015

Development central banking: A review of issues

and experiences

Gerald Epstein

Employment and Labour Market Policies Branch

Copyright © International Labour Organization 2015

First published 2015

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ILO Cataloguing in Publication Data Epstein, Gerald

Development central banking : a review of issues and experiences / Gerald Epstein ; International Labour Office, Employment Policy Department, Employment and Labour Market Policies Branch. - Geneva: ILO, 2015

(Employment working paper ; No. 182)

ISSN 1999-2939 (print); ISSN 1999-2947 (web pdf)

International Labour Office Employment Policy Dept.

banking / monetary system / economic recession / financial market / inflation / stabilization / developing countries

11.02.2

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iii

Preface

The primary goal of the ILO is to work with member States towards achieving full and

productive employment and decent work for all. This goal is elaborated in the ILO

Declaration 2008 on Social Justice for a Fair Globalization,1 which has been widely

adopted by the international community. Comprehensive and integrated perspectives to

achieve this goal are embedded in the Employment Policy Convention of 1964 (No. 122),

the Global Employment Agenda (2003) and – in response to the 2008 global economic

crisis – the Global Jobs Pact (2009) and the conclusions of the Recurrent Discussion

Reports on Employment (2010 and 2014).

The Employment Policy Department (EMPLOYMENT) is engaged in global

advocacy and in supporting member States in placing more and better jobs at the center of

economic and social policies and growth and development strategies. Policy research and

knowledge generation and dissemination are essential components of the Employment

Policy Department’s activities. The resulting publications include books, country policy

reviews, policy and research briefs, and working papers. 2

The Employment Policy Working Paper series is designed to disseminate the main

findings of research on a broad range of topics undertaken by the branches of the

Department. The working papers are intended to encourage the exchange of ideas and to

stimulate debate. The views expressed within them are the responsibility of the authors and

do not necessarily represent those of the ILO.

Azita Berar Awad

Director

Employment Policy Department

1 See http://www.ilo.org/public/english/bureau/dgo/download/dg_announce_en.pdf 2 See http://www.ilo.org/employment.

v

Foreword

The paper argues that central banks should play a broader role in helping developing

countries meet their key challenges, such as generating productive employment, helping to

allocate investment to productivity enhancing activities and helping to tackle the

challenges of climate change. A great deal of work needs to be done to better understand

the optimal institutional and governance structures for central banks in different settings,

the types of goals and instruments most appropriate for different challenges, and the best

kinds of monitoring frameworks to empower central banks to carry out its core

stabilization function while implementing its development goals. Finally, it needs to be

better understood how the central bank can work effectively with other key institutions,

such as development banks, specialized financial institutions and a variety of government

ministries and private actors while, at the same time, ensuring that it is not overwhelmed

with tasks better undertaken elsewhere. To answer these questions, more case studies are

required. General lessons are certainly helpful, but appropriate solutions are to be found in

specific national settings.

Iyanatul Islam

Chief

Employment and Labour Market Policies Branch

Employment Policy Department

vi

Acknowledgement

This paper is prepared for the International Labour Office (ILO) project on

Development Central Banking. Many thanks to the ILO, and especially Azita Berar Awad,

Iyanatul Islam and Kazutoshi Chatani for helpful discussions and support. All remaining

errors are mine alone.

vii

Contents

Preface ...................................................................................................................................................... iii

Foreword ................................................................................................................................................... v

Acknowledgement .................................................................................................................................... vi

1 Introduction ..................................................................................................................................... 1

2. Lessons from the financial crisis of 2007-2008 .............................................................................. 2

3. What’s wrong with inflation targeting? .......................................................................................... 4

4. Development central banking: Historical precedents ...................................................................... 6

5. Development central banking: Targets and instruments and current experience ............................ 8

6. Questions about development central banking.............................................................................. 10

7. Conclusion .................................................................................................................................... 12

References ............................................................................................................................................... 13

1

1 Introduction

In both the developed and developing world, countries face significant

transformational challenges. According to the International Labour Organization (ILO),

global unemployment is over 200 million, with vulnerable employment being almost 50%

of the total; among youth the unemployment rate stands at 13.1% but, in some places, such

as the southern European countries, it is significantly higher. If current trends continue,

these levels of unemployment and unemployment rates are unlikely to decline appreciably

(ILO, 2014). In fact, in some respects, current trends are virtually guaranteed to get worse.

Specifically, climate change, which is already creating considerable economic dislocations

in many parts of the world, is predicted to accelerate over the next decades. It will

especially harm poor and economically vulnerable communities (IPCC, 2014).

Successfully confronting these challenges will require considerable structural

transformations in many countries in a relatively short period of time. With respect to

economic development, reducing unemployment and alleviating poverty, it is increasingly

recognized that successful developers have undergone major structural transformations

focused on employment generation, sectoral diversification, and investment in human

capacities, public infrastructure and technological upgrading in order to achieve an

equitable rise in living standards (Ocampo et al., 2009). Moreover, to confront the looming

perils of climate change, it is well understood that significant investment in renewable

energy and structural transformations in building, transportation and manufacturing will be

required to reduce dependence on fossil fuels sufficiently without doing extreme harm to

the economy and people’s livelihoods (Pollin et al., 2014).

Purely market based solutions are ill suited to such structural challenges, which

require long-term planning and investment in processes involving significant coordination

problems and extensive externalities. Markets, and especially modern financial and

investment markets, tend to be short-term oriented, prone to boom and bust, and poorly

suited to promote long-term investment of the type required for long-term structural

transformation. Successful attempts at dealing with these kinds of structural changes

historically have thus required strong government guidance of the associated market

processes. In modern times, much of this guidance has included institutional mechanisms to

foster long-term orientation and planning with respect to financial markets, credit allocation

and real investment (Zysman, 1989; Amsden, 2001).

Historically, central banks have often been part of the policy apparatus that has helped

to guide and provide financing for these important development and transformational

projects. (Bloomfield, 1957; Brimmer, 1971; Chandavarkar, 1987; Epstein, 2007).

However, with the rise of the “Washington Consensus”, the global drive toward financial

liberalization and the elimination of so-called “financial repression”, central banks were

instructed or chose to follow the increasingly prevalent norm of the “inflation targeting”

approach to central banking. This approach eschews virtually all goals other than keeping

inflation in the low single digits. Its tool-kit was limited to just a few and ideally only one

instrument – a short term interest rate (Bernanke et al., 1999; Anwar and Islam, 2011). This

approach to goals and instruments was accompanied by a drive to change the governance

structure of central banks. Hitherto, they had tended to be integrated into the government’s

policy apparatus but were also potentially subject to inappropriate influence by government

officials. Now, they were able to “independently” implement inflation targeting policy

structures and, especially, resist excessive financing of government expenditures. The result

objectives” or employment among their top priorities, while most list inflation control as

the main goal (Chatani et al., 2014).

Analysts of inflation targeting regimes noted that a “one size fits all” commitment to

low single-digit inflation might not be appropriate either for short-term stabilization or for

longer term growth for many developing countries (Epstein and Yeldan, 2009; Anwar and

2

Islam, 2011). They also noted that a single-minded focus on commodity inflation led

central banks to ignore asset price inflation, inappropriate financial liberalization and the

possibility of asset bubble induced financial crises (Epstein and Yeldan, 2009).

It took the great financial crisis of 2007-2008 to shake up the “Washington

Consensus” and raise significant questions about this central banking norm. The crisis has

thus created intellectual and policy openings in the global discussion of appropriate

economic policies. The ILO study of central bank goals noted that many laws on central

banks and speeches from central bankers in developing countries see “economic growth” as

an important, if secondary objective (Chatani et al., 2014). At the level of the Bretton

Woods Institutions, including the IMF, there has been a process of re-thinking Washington

Consensus policies, including with respect to capital controls and inflation targeting

(Blanchard, 2011; Grabel, 2012). Re-thinking inflation targeting has raised the issue of

multiple mandates for central banks beyond a single-minded focus on low inflation, and a

search for multiple tools of central bank policy. The US Federal Reserve, the Bank of

England and even the European Central Bank (ECB) have all adopted experimental

approaches to central banking, developing new instruments or even dusting off old ones to

confront the challenges of financial crisis and economic stagnation.

In the light of these challenges and the evolution of attitudes toward central banking in

recent years, it is timely to assess the arguments for broader (or multiple) mandates for

central banks, review old approaches and assess new ones for implementing development

central banking. This paper offers a brief survey of the arguments in favour of broader

mandates for central banking, briefly reviews historical experience, summarizes some

recent experience in this type of central banking, and then attempts to answer various

questions and objections that have been raised about this approach. It begins, in the next

section, with a review of the key lessons, changes in attitudes and approaches towards

central banking wrought by the Financial Crisis of 2007-2008.

2. Lessons from the financial crisis of 2007-2008

There are important lessons for the role of central banks in both the build-up to and the

aftermath of the Great Financial Crisis of 2007-2008. The financial systems in the US and

in Europe which generated this crisis had been subject to successive rounds of financial

deregulation, promoted by the banks, which wanted fewer restrictions, and supported by

many economists and central bank officials who believed that liberalized financial markets

would be more efficient and generate more economic growth. Central banks in the rich

countries often saw themselves as the protectors and promoters of this newly liberalized

financial sector and helped to lobby governments for more financial liberalization, or,

where they had the power, implemented de-regulation themselves (Crotty, 2009). In

retrospect, we know that it was these lightly regulated and speculation prone financial

systems that were responsible for the financial aspects of the crisis. And when the crisis hit,

these same central banks used billions and even trillions of dollars to rescue these same

financial institutions, thereby providing a massive subsidy to a subset of one industry in

these countries.

There are two lessons here for our discussion of development central banks. First, as

history shows, central banks have often promoted and subsidized one industrial sector of

our economies, that being the financial sector. So it is not correct to say that modern central

banks do not engage in subsidized credit allocation. The second lesson is that the type of

development or promotional activities that they engage in makes a big difference. In this

recent experience, the type of financial activities that central banks subsidized and

promoted ultimately proved to be rather destructive. Looking ahead, it would seem that, if

anything, a more constructive type of financial sector promotion is certainly called for, one

that contributes to the social productivity of the economy.

3

There are also lessons to be learned from the aftermath of the crisis. Following the

crisis, the United States and Europe have been mired in a state of political paralysis that is

leading to a new norm of fiscal austerity, high unemployment and, in the case of Europe,

economic stagnation. With fiscal policy orientated around austerity, it is the central banks,

the Federal Reserve (the Fed) in the US, the Bank of England and the European Central

Bank (ECB), that remain the only macroeconomic authorities with the authority and

political power to try to revive these struggling economies.

As in previous severe economic crises, these central banks find that they have to

engage in policy experimentation and innovation in an attempt to extract their economies

from the jaws of crisis (IMF, 2013). The Federal Reserve created multiple new mechanisms

and facilities to carry out “lender of last resort” activities and engaged in three rounds of

quantitative easing (QE). The Bank of England also implemented QE and instituted special

facilities to promote home mortgages. The ECB has been more constrained by the

perceived opposition of Germany and certain constitutional strictures, but, nonetheless, has

instituted special small business loan facilities and is likely also to implement QE, probably

sooner rather than later.

Moreover, at the Fed, under both Janet Yellen and Ben Bernanke, there has been a

shift from inflation targeting to employment targeting, as the jobs crisis is ongoing and

inflation is securely in check.

These attempts to develop new instruments with which to implement monetary policy,

and sometimes emphasize new targets have been endorsed even in some unlikely bastions

of orthodoxy. In a highly publicized presentation, Olivier Blanchard, Chief Economist at

the IMF insisted (March, 2011),

Before the crisis, mainstream economists and policymakers had converged on a beautiful

construction for monetary policy. […] we had convinced ourselves that there was one target, inflation.

There was one instrument, the policy rate. And that was basically enough to get things done. If there is

one lesson to be drawn from this crisis, it is that this construction wasn't right, that beauty is

unfortunately not always synonymous with truth. The fact is that there are many targets and there are

many instruments.

While Blanchard was referring primarily to the need for central banks also to target

financial stability, his point is actually more general than that. The need for central banks to

adopt multiple instruments and targets, however belated its current recognition, is a

hallmark of the challenges facing not only central banks in the throes of crisis, but also

central banks in economies grappling with the long-term challenges of economic

development.

However important it may be for central banks to take on these broader roles and

adopt an innovative array of instruments to implement them, it should be emphasized that

they cannot “do it alone”. Indeed, far from it. This is one of the key lessons of the

mismanaged response in the U.S., the U.K. and Europe to the financial crisis. Fiscal policy

has abandoned the economy and as a result, all the onus of recovery has been placed on

monetary policy. Monetary policy, however, cannot carry the whole burden. Expansionary

monetary and credit policy has left interest rates stuck at the zero lower bound, and QE and

other modest experiments have failed to revive the economy, however much they may have

stemmed a dramatic further decline.

Developing countries, then, must learn two lessons, one positive and one negative,

from this chequered response by the rich countries’ macro-policy makers. The positive

lesson is that, like the Fed, Bank of England and ECB, developing country central banks

can play a larger role in meeting the challenges of development and transformation if they

eschew the flawed advice to pursue inflation targeting with one instrument, and instead

broaden their goals and instruments to tackle those challenges. However, the second, and

more negative lesson, is that the broader government and fiscal authorities must do their

4

share to develop and expand their economies. Central banks cannot do it on their own. In

other words, there must be monetary and fiscal cooperation and an attempt thereby to

achieve coherence between macroeconomic and development objectives by both the

monetary and fiscal authorities. This suggests the traditional advocacy of so-called “central

bank independence” needs to be re-visited.

3. What’s wrong with inflation targeting?

No matter how much policy makers such as Olivier Blanchard question inflation

targeting in the rich countries, it is still widely seen as the current “best practice” for

developing countries. Yet this approach has serious limitations as a framework for

monetary policy in developing countries (Epstein and Yeldan, 2006; Anwar and Islam,

2011). In its strict form, inflation targeting posits that central banks should have only one

objective, low and stable inflation, and should utilize only one policy instrument, usually a

short-term interest rate. As a corollary, the conventional wisdom usually promotes the idea

that central banks should be “independent” of the government, in order to enhance their

ability to reach the inflation target. This is usually justified on the basis of avoiding time

inconsistency and resisting pressures from governments to finance fiscal deficits.1

Even if one believes that this general approach is a good one, a key question arises:

what is the appropriate inflation rate? The standard practice is that countries should try to

maintain inflation in the low single digits (Anwar and Islam, 2011). Where does this

number come from? One might expect that a number designed to guide the making of

monetary policy in many parts of the globe would come from rigorous research and a broad

consensus that the optimal rate of inflation for developing countries is in the low single

digits. However, nothing could be further from the truth.

The theoretical case for an optimal inflation rate in the low single digits is very weak,

largely because inflation plays no central role in the fundamental general equilibrium

models that underlie most welfare analysis. In terms of growth theory, the results are

ambiguous. Early work by James Tobin (1965) and Foley and Sidrauski (1971) shows that

higher inflation can lead to higher economic growth by lowering the rate of return on

financial assets relative to real capital and thereby leading to more investment. Under some

model parameters or different model structures, though, the impact can go the other way.

Hence the issue comes down to an empirical question.

On the empirical front, however, there is no credible evidence that inflation in the low

single digits is the optimal inflation rate for developing countries. Bruno and Easterly

(1996) find little evidence of a negative relationship between inflation and growth with

inflation rates less than 40%. More recent studies, including those that look at non-

linearities and threshold effects find that, for developing countries, growth starts declining

on average when inflation rates hit between 14% and 18%. (Pollin and Zhu, 2009; Anwer

and Islam, 2011). This is a far cry from 4 6% or less, which is a typical target range for

developing countries.

1 Proponents of inflation targeting often distinguish between “goal independence”, i.e. who determines the

inflation target itself, and “instrument independence”, i.e. who determines the means of achieving the target.

The standard advice is that governments, in conjunction with the central bank should choose the goal (target)

and the central bank should have the independence to determine and implement the means. This is often,

however, a meaningless distinction. Firstly, once a country adopts an inflation targeting regime, by convention

it also adopts the range of inflation targets that are commonly promoted: these are in the low single digits.

Secondly, once the basic framework is adopted in which the instruments are limited to only one major target

(short-term interest rates), the policy response is pretty much predetermined. In this case, the global

“norm/conventional wisdom” of inflation targeting as currently conceived imposes a strict framework that often

gives central bankers, who usually endorse this policy, the upper hand in the relationship.

5

This raises the question of why inflation targeting regimes identify such a low

inflation rate as the optimal rate, even though there is no evidence that this is valid in the

case of developing countries. There is accumulating evidence that a long-standing

suspicion about group preferences with respect to inflation, going back at least as far as

Keynes, is true: namely, that the financial sector has a stronger dislike of inflation than

other groups in society (see, for example, Jayadev, 2008), and that this dislike of inflation

helps to explain central bank behaviour (Epstein, 1994; Posen, 1995).

This inflation aversion of the financial sector also points to a problem with so-called

central bank “independence”. In a democratic society, there is no such thing as political

independence. All institutions are political in nature and need political constituencies to

protect their authority and prerogatives. “Independent” central banks typically nurture close

relationships with finance for support, leading to a political and economic symbiosis

(Epstein, 1994). As Milton Friedman noted decades ago, independent central banks are

likely to be too close to the “commercial banking” sector rather than making policy in the

public interest (Friedman, 1962). As a result, independent central banks often tend to

pursue excessively anti-inflationary policies.

Choosing the wrong target would not matter if undershooting had no negative impacts

on important economic variables, such as employment, wages and growth. In practice,

however, it would seem that excessively restrictive monetary policy can lead to excessively

high real interest rates, and, with open capital markets, can lead to capital inflows, over-

valued real exchange rates, and harm exports and reduce employment and growth (Epstein

and Yeldan, 2009; Rodrik, 2008).

In practice, targeting inflation with increases in interest rates might be a startlingly

incorrect assignment of instruments to targets. Much inflation in developing countries is

due to supply or external shocks (Heintz and Ndikumana, 2010; Anwar and Islam, 2011).

Responding to a supply shortage or an external price increase with a policy designed to

reduce domestic demand can sometimes add insult to injury. It could worsen the problem

by reducing capacity further or, in the case of external shocks, create collateral damage by

leading to an over-valued exchange rate.

A further key problem for inflation targeting in developing countries, is that the

transmission mechanism between traditional monetary policy and the macro-economy in

many developing countries is weak (Mishra et al., 2010; Mishra and Montiel, 2012). The

main problem is that when the central bank increases the money supply to try to lower

interest rates and expand credit, the banking system is not very responsive. It often fails to

lower interest rates on loans proportionally, thereby allowing interest margins to rise. This

increases their profits but does not commensurately lower the cost of credit. Moreover, the

financial system often fails to provide new credit to relatively underserved groups, such as

small businesses (SMEs) or small farmers. On the other hand, when the central bank

increases interest rates in an attempt to slow inflation, the commercial banks are quick to

increase rates and widen interest rate margins.

Clearly, a restructuring of the financial system will be required if monetary policy is to

be more effective in achieving any targets, including inflation control.

These examples illustrate a key flaw in the conventional arguments for inflation

targeting: the idea that by delivering a low and stable inflation rate, inflation targeting

central banks will help deliver both macroeconomic stability and economic development

objectives to developing economies. The conventional argument is that stable prices will be

sufficient to provide macroeconomic stability and that if there is macroeconomic stability

(and other appropriate market institutions such as appropriate property rights) then private

investment will flourish and economic development is likely to follow. (In the extreme

version of this argument, inflation targeting and appropriate property rights enforcement is

sufficient to deliver both macroeconomic stability and economic development).

6

However, as the previous examples illustrate, inflation targeting by central banks does

not necessarily deliver macroeconomic stability. In developing economies with liberalized

domestic financial markets and with economies integrated into global capital markets,

inflation targeting can be associated with de-stabilizing capital flows and outflows (sudden

stops), cycles of over-valued exchange rates and crashes, destabilizing allocation of credit

to real estate and other types of speculation. The consequence is short-term investment

cycles that hinder long-term investment in industries associated with dynamic comparative

advantage, upgrading and long-term employment generation (Epstein and Yeldan, 2009;

Ros and Galindo, 2009).

In other words, macroeconomic policy focused on inflation targeting is likely to

deliver neither macroeconomic stability nor economic development.

Partly as a result of these problems, many central banks implement inflation targeting

more in the breach than in the practice. Missed inflation targets have become commonplace

even in countries that claim to adhere strictly to their target. While some take this as

evidence that central banks are losing discipline, it might be more accurately taken to

reflect that inflation targeting is an inappropriate framework for macro-policy guidance for

countries trying to navigate the treacherous waters of a financialized global economy.

What is the advantage of pretending to adhere to strict inflation targeting when, in

fact, like their counterparts in the developed world, developing country central banks are

innovating and experimenting out of necessity to deal with the economic problems they

face.

Would it not be better for these central banks to admit that achieving a moderate level

of inflation is an important goal, but only one of several important issues facing their

economies? In that case, central banks could play a more active role as part of government

initiatives to confront the major macroeconomic challenges facing their economies.

4. Development central banking: Historical precedents

If inflation targeting is not the best monetary policy framework for achieving broad

economic and social goals, then what kind of central bank frameworks –goals, governance

and instruments – are likely to best help developing countries address the key problems

they face? Important lessons can be learned from history with respect to the kinds of central

bank frameworks that have been tried and those that have been successful in achieving

macroeconomic stability and economic development (Epstein, 2007, 2013)

Historically, central banks in both developed and developing countries have done as

Olivier Blanchard suggested: they have focused on multiple targets and, following the rules

of Tinbergen, utilized multiple instruments to achieve these targets (Tinbergen, 1952).

Following the Second World War, central banks in Europe and Japan utilized interest rate

ceilings, subsidized credits and other credit allocation policies to facilitate economic

reconstruction and industrial upgrading (Hodgman, 1973; U.S. Congress, 1972, 1981;

Zysman, 1983).

Also after the Second World War, there was a major transformation of central banking

in the developing world. In many respects, these changes paralleled those in the developed

world just described. But in developing countries, central banks were much more

emphatically agents of economic development than in many richer countries. As reported in

1957 by renowned monetary historian of the New York Federal Reserve, Arthur I.

Bloomfield (Bloomfield, 1957, p. 190.)

During the past decade there has been a marked proliferation and development of central banking

facilities in the underdeveloped countries of the world, along with an increasing resort to the use of

7

monetary policy as an instrument of economic control. Since 1945, central banks have been newly

established and pre-existing ones thoroughly reorganized, in no less than some twenty-five

underdeveloped countries. In other cases the powers of pre-existing central banks have been broadened

.in large part the recent growth of central banking in the economically backward areas has also reflected

a desire on the part of the governments concerned to be able to pursue a monetary policy designed to

promote more rapid economic development and to mitigate undue swings in national money incomes.

Bloomfield goes on to describe the functions, powers, and goals of these central banks

(ibid., p. 191).

Many of the central banks…are characterized by unusually wide and flexible powers. A large

number of instruments of general and selective credit control, some of a novel character, are provided

for. Powers are given to the central bank to engage in a wide range of credit operations with commercial

banks and in some cases with other financial institutions.

Some of these measures are admittedly outside the traditional scope of central banking, but central

banking in these countries should not necessarily be evaluated in terms of the standards and criteria

applied in the more developed ones….the central bank can seek to influence the flow of bank credit and

indeed of savings in directions more in keeping with development ends (ibid., p. 197).

Bloomfield also describes the tools of credit manipulation:

..selective credit controls applied to the banking system, through help in establishing and supporting

special credit institutions catering to specialized credit needs, and through influence over the lending

policies of such institutions, it can help to some degree to re-channel real resources in desired directions,

both between the public and private sector and within the private sector itself.” (ibid., p. 198).

although he cautions that:

Such measures would for the most part be justified, however, only to the extent that they do not

conflict with the overriding requirement of financial stability or involve the central bank in details of a

sort that might distract its attention and energies from the effective implementation of a policy aimed at

stability (ibid; p. 197).

Writing about the same issue almost fifteen years later (in 1971), another prominent

Federal Reserve official, Andrew F. Brimmer, a member of the Federal Reserve Board of

Governors, looked back on the experience with “development” central banking in the

developing world. Brimmer and his associates describe a variety of techniques that central

banks pursued in the 1960s. These included: providing capital to development institutions,

such as industrial and agricultural development banks; extending credit to development

banks and purchasing their securities; buying a small part of the equity of development

banks; establishing a “securities regulation fund” to create a market for the securities of

various development finance institutions, by using the profits from the ordinary operations

of the central bank; using differential discount rates to allocate credit to capital

development projects ; the establishment of portfolio ceilings on activities having a low

priority; various types of reserve requirements, including differential reserve requirements

to influence the allocation of credit ; using import deposit requirements (primarily intended

to deal with balance of payments difficulties) to also influence the allocation of bank credit

(Brimmer, 1971).

Brimmer, on the whole, is somewhat negative about the effectiveness of many of these

techniques, with the evidence from his study providing mixed results about the

effectiveness of these policies. The possible trade-off between development central bank

and the maintenance of financial and macroeconomic stability is also a continuing concern.

In the late 1980s, an IMF adviser, Anand G. Chandavarkar, revisited these same

issues. He referred to the development role of the central bank as a “promotional role”.

(Chandavarkar, 1987). Like Brimmer, Chandavarkar was somewhat concerned that central

banks might overstep their capacities while becoming too subservient to the central

government. At the same time, he recognized that in poor countries, central banks, being

among the main public repositories of both financial and human capital, had important

8

comparative advantages and responsibilities to help promote development goals, primarily

through promoting a development friendly set of financial institutions.

Alice Amsden reports that the role of medium and long-term financing, often

supported by central banking mechanisms as just described, were the key to the “Rise of the

Rest” (Amsden, 2000). The countries of the rest, according to Amsden, acquired a

manufacturing base in the years prior to World War II and then, after the war, industrialized

rapidly, moving eventually into mid-level and even high-technology production (ibid, pp 1-

2). Among many other factors, Amsden stresses the important role of finance in the success

of these countries, especially the mobilization and allocation of medium and long-term

finance for industrialization.

Though not emphasized by these authors, a number of complementary, and key, roles

were played in these economies by capital controls: they served to help preserve a stable

and competitive real exchange rate by limiting speculative capital inflows; they helped to

limit destabilizing leverage on domestic balance sheets by limiting currency and maturity

mismatches by companies, governments and households; and they helped to protect the

apparatus of subsidized credit and credit allocation mechanisms by limiting capital

outflows and cross-border arbitrage (Nembhard, 1986; Epstein, Grabel, Jomo, 2003).

Similar policies have been successfully employed as complements to industrial

development by many countries, including China, South Korea and Taiwan, among others.

In response to the financial crisis of 2007-2008, interest in capital controls has become

more widespread as a prudential management tool. More commonly termed capital

management techniques (CMTs), or capital account regulations (CARs), these tools have

become increasingly recognized, even by institutions previously opposed to them such as

the IMF, to be useful parts of the macroeconomic stability toolkit (Grabel, 2013; Gallagher

and Ocampo, 2013; Erten and Ocampo, 2013).

However, it would be incorrect to draw a clear distinction between these “short-term”

stabilization aspects of capital account regulations and the longer term impacts on

development and structural transformation. Reducing hot money flows, limiting excessive

currency and maturity mismatches on balance sheets, limiting capital account driven

speculative investments and maintaining a competitive and stable real exchange rate can be

crucial to maintaining both macroeconomic stability and the policy space required to

achieve economic development and economic transformation (Epstein and Yeldan, 2009;

Ocampo, Rada and Taylor, 2009).

5. Development central banking: Targets and instruments and current experience

In the light of the crisis, central banks in the developed world are broadening their

approach to central bank policy beyond simple inflation targeting. Some movement toward

embracing a broader set of concerns beyond a single minded focus on inflation can also be

found in the developing world. Chatani et al. find that the founding statements of 40 out of

the 51 developing country central banks they studied include “economic growth” as an

objective of policy. Eighteen of the 40 place growth as a secondary concern after price

stability, but the other 22 either place growth on a par with price stability or place it above

price stability on the priority list (Chatani et al., 2014).

They also find that 38 out of the 51 central banks in the study include exchange rate

stability as an objective.

Thus, a significant number of central banks have multiple targets even if price stability

is one of the most important, or even the most important. Chatani et al. (2014) also include

a content analysis of speeches by central bankers in their sample. These speeches are

9

consistent with their findings from the founding documents: most speeches mention price

stability, but many also mention economic growth and investment as an issue of

importance. Relatively few speeches, however, mention employment as an important issue,

despite the obvious importance of employment to broad-based social well-being (Chatani et

Al., 2014).

A handful of central banks in the developing world are embracing more specific

development goals and developing a broader set of tools to achieve these goals. The Central

Bank of Bangladesh has pioneered a variety of policies partnering domestic commercial

banks and local cooperative institutions. They include providing subsidized credit for small

businesses, improving renewable energy use in agriculture while increasing assets for small

farmers and helping to develop agricultural assets for landless farmers (Epstein, 2013;

Muqtada, 2014). The Central Bank of Argentina has also adopted a new set of development

mandates (Del Ponte, 2013; Epstein, 2013). In March 2012, the Argentine Parliament

approved a new charter for the Central Bank of Argentina, a charter that embodies some

key goals of development central banking. Article 3 of the new Charter states that “the

purpose of the Central Bank is to promote monetary stability, financial stability,

employment and economic development with social equity, within the scope of its powers

and under the framework of the policies determined by the national government.” (Del

Ponte, 2013; Central Bank of the Republic of Argentina, July 2012). Perhaps most

importantly, the reform allows the bank to provide funds for domestic banks and other

financial institutions involved in the financing of long-term productive investment.

These new initiatives include:

1. Medium and long-term lending for productive investment

The Central Bank has initiated the “Bicentenary Productive Financing Programme”

with the aim of increasing productive investment. To do this, the Central Bank gives a line

of credit to banks to enable them to make longer term loans (a minimum of 2 ½ years) to

finance longer term productive investment. (BCRA, 2nd Half 2012, p. 8) The Central bank

instructed banks to set up a credit line for the financing of investment projects. The loans

are for a term of 24 months or more, (with an effective maturity of at least 36 months) with

a fixed interest rate of no more than 15% annual. By the end of 2012, each financial

institution with at least 1% of the country’s deposits, or which act as government agents,

should have granted an amount equivalent to 5% of its deposits. Half of this was to be

granted to micro and small and medium-sized companies.

2. Extending the geographical coverage of banking

A new system for licensing branches was implemented to encourage the extension of

banking facilities to under-served areas. This should reduce financial exclusion and provide

the basis for more credit provision later.

Unfortunately, the Argentinian economy has been faced with a number of difficulties

resulting partly from the political and economic fallout from the crisis of the early 2000s,

and compounded by shocks from the global financial crisis. As a result, the central bank is

finding it challenging to implement these new policies to the full. Nevertheless, the change

in mandate is significant and when the economy stabilizes, presumably it will have more

breathing room to implement this new approach more fully.

In a number of countries, broader central bank activities are taking place under the

umbrella of financial inclusion policies (World Bank, 2013, 2014). For example, the

Ecuadorian Central Bank has explicitly adopted a financial inclusion mandate (Arias,

2014). This mandate includes utilizing central bank initiatives to increase banking and

finance access to the unbanked (Arias, 2014). The Ecuadorian case is interesting because it

shows that a broadening of central bank mandates is possible even in a highly dollarized

environment. Cambodia is another case of a highly dollarized economy in which the

10

Central Bank has explicitly adopted a policy of trying to enhance financial inclusion.

(Vouthy et al., 2014).

In the case of Pakistan, the central bank has historically had the mandate to play a

broad role in promoting financial institutions and providing financial support for

underserved sectors such as agriculture, small and medium-sized enterprises and

manufacturing. With the rise of financial liberalization, these roles have been significantly

reduced, but much of the legislation underlying these broader roles remains in place and

could be re-activated, should the government choose to do so (Sayeed and Abbasi, 2014).

Despite some increased movement along the lines of broader initiatives, increased

concern for growth promoting central bank activities, more official sanction for policies of

financial inclusion and some types of capital management techniques, these initiatives are

still relatively small and still concentrated in a relatively few countries. To some extent,

they have been limited by the continued strength of the persistence of the conventional

wisdom concerning the need for inflation targeting and central bank independence as key

bulwarks of macroeconomic stability and prudent macro-economic governance. The next

section addresses some of the common concerns over development central banking.

6. Questions about development central banking

The upshot of the discussion so far is that the Great Financial Crisis has generated

some cracks in the “new monetary consensus” of one target (inflation) and one instrument

(the policy interest rate) with a recognition that it is not sufficient to meet the

macroeconomic and development challenges that many countries face. These cracks are

broad ranging and include: discussions at the centres of macro-policy orthodoxy, such as

the IMF; debates over central bank mandates that highlight the dual-mandate of the Federal

Reserve (high employment and price stability); the emphasis from the Bank for

International Settlement (BIS) and elsewhere on the need for central banks to take into

account financial as well as price stability; the monetary experimentation in core central

banks; creation of development central bank mandates in several countries including

Bangladesh, Argentina and others; and finally, the flagrant violation of inflation target

strictures by many central banks that claim to engage in “inflation targeting lite”.

Nevertheless, central banks and policy makers more generally have been reluctant, to

put it mildly, to embrace a new consensus that central banks should become integral

partners in a macroeconomic initiative to confront key challenges. The consensus, at best, is

that there can be some tinkering around the edges of inflation targeting. This is indicative of

a reluctance to recognize the broad changes that are actually taking place in monetary

policy management in response to the crisis.

Possible objections that have been raised to a more development approach to central

banking and some responses to these objections include the following. First, why is the

“assignment problem” not the most efficient solution to this problem? According to

Tinbergen, there should be as many instruments as targets. So why not just assign the

central bank to macroeconomic stability and the fiscal authority to development? There are

many problems with this solution. As discussed above and further below), even achieving

macroeconomic stability itself requires more than simply targeting inflation. In addition,

there is too much uncertainty in macroeconomic policy making so that there needs to be

genuine coordination and learning by doing. Finally, as Tinbergen noted, policy

instruments are not independent of each other. Thus changes in one instrument, say the

interest rate, will not only affect inflation, but will also affect employment and the real

exchange rate, which have a big impact on development. It has been known for decades that

these instrument interdependencies can render a decentralized “assignment problem” costly

and even unworkable.

11

The second objection is that there is a trade-off between development central banking

and macroeconomic stability. It is true that, in the past, some developing countries that had

central banks with broad powers and little distance from government, were part and parcel

of macroeconomic regimes that were associated with failed macroeconomic policies. At the

same time, there are many examples, as described above, where central banks that were

partners in development-oriented macroeconomic policies led to more rather than less

economic growth and macroeconomic stability. In these cases, such as the industrializing

Asian countries and Europe and Japan after the Second World War, directing credit to

rising industries rather than commodity or real estate speculation actually contributed both

to macroeconomic stability and to economic development. Here macroeconomic stability

and development were complementary results of development central banking, not

substitutes. The lesson then is simple: the need is for good policies and appropriate policy

coordination, together with appropriate checks and balances, so that central banks can play

a positive role in fostering both macroeconomic stability and development. Pretending that

a singular focus on inflation control will lead to either macroeconomic stability or

economic development is not, as has been observed, a winning policy.

A third and related concern is that if central bank policy becomes too highly

coordinated with government policy, including fiscal policy, then the some governments

will try to abuse their powers with respect to the central bank by exerting inappropriate

pressure on it to fund fiscal deficits, or even to support cronyism or corruption. In some

countries, or even in all countries at some time, these worries may be legitimate. It may be

wise, then, for there to be checks and balances, including a certain degree of operational

independence, to give the central bank some insulation from direct control by the

government. At the same time, it is often important for the central bank’s policies to be

coordinated with the government’s development plan. For example, even corrupt

governments usually have development plans. The central bank could usefully orient its

policies around promoting the key macroeconomic goals of the development plan, even

when a corrupt government is failing to achieve the plan. In this case, of course, this might

entail the central bank leaning against the wind with respect to the government’s actual

policies, though not the government’s publicly announced development plan. In the more

common, and general, case the central bank’s policies would be coordinated with those of

the government.

A fourth objection is that central banks do not have the knowledge to generate

employment, support investment in key industries or target the real exchange rate. While

there might be some truth to this, rather than supporting the continuation of a focus on

inflation targeting, it points to a key reason why a broader mandate is useful and even

necessary in many countries. Central banks in developing countries often have one of the

largest pools of highly trained and skilled economists and technicians. In an inflation

targeting regime, this collection of highly scarce human resources is being utilized to learn

everything that can be possibly learned about movements in commodity prices and their

connection to monetary policy. They spend almost no time or energy learning how

monetary and credit policy affects employment, skills upgrading, technological

development and sectoral growth. If central banks were given a broader mandate, then their

staff would have to learn more about the economies in which they operate. They might

have to talk to labour ministries, agricultural ministries, and women’s associations about

how their policies affect women and children and the environmental ministries about the

impact of policies on the environment. In this case, some of the skilled labour in central

banks can be deployed to understand how monetary policy can affect these broader issues

and this would be likely to generate a considerable increase in their social and economic

productivity.

A final objection is that one should not ask central banks to do too much. Central

banks cannot do everything; they are not a panacea.

12

This point is well taken. Central banks should be seen as one key macroeconomic and

financial institution that must work in concert with other key financial and macroeconomic

institutions. As discussed earlier, latterly Asian country developers have utilized

development banks to help finance and coordinate their industrial policies. Today,

development banks can once again play key roles in helping to mobilize long-term or

patient capital for development purposes. Central banks can play a supporting role in

providing lines of credit, credit guarantees, and the like for high quality projects. They can

further help out by maintaining a stable, competitive exchange rate. Lastly, they can help by

playing a coordinating role among various macroeconomic and sectoral agencies and

private finance.

So it is true that central banks cannot provide all of the solutions to the development

challenge. However, if they abandon or at least strongly modify their current inflation

targeting structure to become more development-oriented, they can become a much bigger

part of the solution than they have been in recent years.

7. Conclusion

In the light of these arguments, there is a strong case that, in general, central banks

should play a broader role in helping developing countries meet their key challenges, such

as reducing unemployment, generating more decent work, helping to allocate investment to

productivity enhancing activities and helping to tackle the challenges of climate change.

Much more work needs to be done to better understand the optimal institutional and

governance structures for central banks in different settings, the types of goals and

instruments most appropriate for different challenges, and the best kinds of monitoring

frameworks to make sure that central bank policy has the checks and balances it needs to

carry out its stabilization function while implementing its development goals. Finally, it

needs to be better understood how the central bank can work effectively with other key

institutions, such as development banks, specialized financial institutions and a variety of

government ministries and private actors while, at the same time, ensuring that it is not

over-burdened with tasks better undertaken elsewhere. To answer these questions, more

case studies are required since, in the end, though general lessons are helpful, the true

solutions are to be found in specific national settings.

13

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